Hedge Funds

My piece on hedge funds is up now.

You’ve probably heard about hedge funds. Hedge funds are private pools of money, on the orders of billions of dollars. They are usually secretive. Ten thousand hedge funds are registered in the Cayman Islands. Why are they registered in the Caymans? So they can be secretive and avoid taxes.

Journalists tend to be naturally suspicious of secrecy, but there are good hedge funds. Ones that have a very narrow strategy they pursue. That don’t borrow huge amounts of money, that don’t speculate and drive up the price of oil or drive down the price of Ford, and that generally don’t concentrate on investments that almost nobody understands.

But the bad ones can be really bad. Because they move so much (borrowed) money in and out of the markets, they are blamed for the extreme market gyrations we’ve seen in the past few weeks. They will speculate on anything. The spectacular collapse of Long-Term Capital Management in 1998 had much to do with its bets on volatility itself.

So why do people invest in hedge funds? Well, not everybody does. Minimum investment is $5 million or so. And 20 percent of all profits goes to the fund managers, some of whom earned $1 billion in a single year.

Even with those huge hurdles, hedge funds managed $2 trillion when things were going well. And they did extremely well for their investors.

Those who did invest in hedge funds were sometimes drawn in by the promise of absolute return. That hedge funds will use sophisticated trading techniques and will always make money. No matter what. Long-Term Capital Management was run by a Nobel Prize winner who convinced people that the fund’s mathematical models guaranteed returns. Until they didn’t.

Long-Term Capital Management lost $4.5 billion in nine months in 1998. The Federal Reserve decided to intervene because it feared the fund’s collapse could trigger a full-blown panic.

Today, 10 years later, there are many more hedge funds. They have been wildly successful over the past seven years, helped once again by Alan Greenspan’s cherished beliefs in cheap money and unfettered markets. And success is a very bad teacher, as Bill Gates says. Because it seduces smart people into thinking they can’t lose.

Bloomberg reports that hedge fund assets will fall to $1 trillion by mid-2009. Some hedge funds lost quite a bit of money. Quite a few investors cashed out and fled to safety. And if Citigroup is right, we should remain seated because the turbulence is going to with us for some time.

So, I’ll be learning and writing more about hedge funds in the coming weeks. As always, I welcome comments, thoughts, criticisms, and musings, anonymous or not.